Chemicals Monthly – Down Come the Estimates – Again

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SEE LAST PAGE OF THIS REPORT Graham Copley / Nick Lipinski

FOR IMPORTANT DISCLOSURES 203.901.1629/203.989.0412

graham@/lipinski@ssrllc.com

November 16th, 2012

Chemicals Monthly – Down Come the Estimates – Again

  • The Q3 earnings season provided the expected negative guidance even from companies that had seen significant downward revisions through Q3.This has been particularly true for the product and geographically diverse large cap names.
  • Another high priced coatings deal (SHW and Comex) is seen as positive by investors; our review remains that this sub-sector looks extremely valued. Coatings companies will struggle to deliver the returns discounted in valuations.
  • Convergence in the oil and natural gas market favors the more diversified US ethylene companies in the near-term – so DOW rather than WLK. However, feedstock volatility has been one cause of earnings surprises to the downside this year, so we should not get too excited based on a couple of data points.
  • A review of commodity production cost shows that propane is becoming a very attractive feed for ethylene production. This has implications for propylene and polypropylene pricing as well as other ethylene byproducts. This may make the economics of direct propane to propylene production look less attractive.
  • A review of cash flows and cash deployments suggests that all sub-sectors could meaningfully increase dividend payments and have a positive impact on valuations.

Exhibit 1

Source: SSR Analysis – See Appendix 1 for background and see Appendix 2 for a larger version of this table.

Overview

The quick conclusions from this month’s analysis are as follows.

  • The Chemicals subsectors have all seen negative absolute performance since our last report, though on a relative basis only the Commodity subsector meaningfully trailed the S&P. The Coatings sub-sector was among the most resilient to the recent market selloff but, in our opinion, remains at, or near, peak valuation.
  • The strength in the Coatings subsector has negatively impacted our model portfolios; on the short side, SHW screens as one of the 5 most overvalued companies in our Chemicals universe, yet continues to defy our expectation of a valuation correction.
  • October ISM data showed continued improvement on the domestic front; PMI numbers were above the expansionary level of 50 for the second consecutive month. Yet the situation in Europe is as tenuous as ever; Euro area GDP contracted for the second consecutive quarter, technically indicating a recession.
  • We have begun to see the M&A activity that we anticipated in last month’s Chemicals review, a recent blog and recent research. However, in our view, companies (and shareholders) may be better served if cash is deployed in the form of dividends rather than acquisitions.
  • Pricing dynamics related to the production of natural gas in the US have propane looking increasingly attractive as a feedstock, possibly benefitting those companies with facilities capable of changing feedstocks.

Valuation

Exhibit 2 summarizes our valuation work. The Coatings subsector has pushed higher still in recent weeks, driven by the boost to SHW on news of its $2.3 billion acquisition of Mexican rival Comex. In October’s monthly Chemicals piece we cited the weak demand environment and overoptimistic earnings expectations as possible drivers of deals in the sector; however, despite this deal’s apparent benefits to Sherwin Williams, we would continue to caution buying into the Coatings space in general, which is currently 2.5 standard deviations above normal value. Prior work focused on ROC, gross margins and dividends indicate that Coatings’ current fundamentals do not warrant this premium valuation. The Diversified Chemicals group overcame widespread negative revisions to sneak back above mid-cycle value after briefly dipping below last month. ECL and IFF outperformed in the weeks since our last report and though some of those gains have been pared recently, they have still moved the Specialty subsector into “expensive” territory.

Exhibit 2

The group composition is summarized below.

Exhibit 3

Exhibits 4 and 5 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our October Chemicals Monthly . Industrial Gases was the best performing sector over this span and its outperformance has the group beginning to look expensive on our valuation framework at 1.11 standard deviations above normal. The Diversified subsector was virtually flat while the Commodity space was the biggest loser. (LyondellBasell fell more than 7%).

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Monthly Topic 1: Dividends Revisited

This month we follow on from the general industrial piece that we wrote earlier this month and look at how much chemical companies could be paying as dividends. Most subsectors are spending below depreciation levels on new plant and equipment, yet dividend payments look low as a proportion of EBT and given high valuations and low growth, we would like to see cash returned to shareholders and not gathered for a potentially value destructive acquisitions. We are seeing some high priced acquisitions in the coatings space – all for cash – at what we believe are peak valuations. Looking back at the work that we did on M&A earlier in the year , the Chemical industry does show some success from a shareholder return perspective from acquisitions. However, it is not clear that the relative shareholder returns in terms of increased valuation would have been better had the cash been to raise dividend payments or buy back stock.

The performance of the stocks in our Chemical universe this year is listed in Exhibit 6, together with the dividend increase this year. The trend line goes in the right direction, but the correlation is very poor and there are clearly plenty of other factors driving valuation which we will address in separate research.

Exhibit 6

Source: Capital IQ and SSR Analysis

There are a handful of companies spending a great deal on new capacity and others that have substantial capital spending plans for the medium term. As a reminder, and as illustrated in Exhibit 7, this sector does not have a good return on capital history and has taken significant write downs over time, suggesting poor acquisition spending in addition to poor capital spending.

Exhibit 7

Source: Capital IQ and SSR Analysis

If this capital spending could be curtailed and taking the same tack that we took in the broader piece on increased dividend payouts we get the results summarized in Exhibit 8. If companies were to raise their permanent divided policy to a payout of 70% of normal EBT, dividends could be increased dramatically. Each sub sector could increase dividend payments by at least 100% and specialty chemicals by more than 300%.

Exhibit 8

Source: Capital IQ and SSR Analysis

As for the broader industrials space, the chemicals group is currently spending in new plant and equipment at around the rate of depreciation – Exhibit 9. If this can be maintained and if companies can stay away from expensive acquisitions, there is no reason why the dividend rates illustrated above cannot be achieved. On a normalized basis, companies would then be limited to capital spending levels equal to depreciation, or would need to raise debt or equity to invest above depreciation levels in the same way that Williams Partners has done to acquire the ethylene and pipeline assets from Williams Companies.

Exhibit 9

Source: Capital IQ and SSR Analysis

In Exhibit 10 we take a more granular look and break the analysis down by subsector. We make the following assumptions:

  • The subsectors only get half of the upside suggested by the increase in yield – although we are suggesting a fixed dividend payment, this may be a conservative assumption in the sectors where earnings have more limited volatility and where investors therefore have more certainty that a fixed payment is sustainable.
  • The ROC is the current value of the trend lines we created in the first piece of research we published this year
  • We assume that 2011 capital spending (which is below trend for almost all sectors), is a good proxy for net capital spending. The risk here is that we are overestimating net capital spending, in which case the number of years required would increase as capital would grow more slowly.

Exhibit 10

Source: Capital IQ and SSR Analysis

There is a great deal of upside in valuation from increasing dividends on a permanent basis – upside in many cases that would take years of capital spending to achieve, all things being equal. Please see the piece we published earlier this month for a more complete description of the methodology used here.

Monthly Theme 2: Changing Commodity Dynamics –The Rise of Propane

Over the last couple of years, the rise of crude oil prices combined with the collapse of natural gas prices has heralded a period of great economic advantage in the US for ethylene producers that are equipped to handle ethane as a feedstock. Profits have increased and facilities that have the ability to change feedstocks have made lots of money – WLK has seen its net income rise seven fold from 2009 to 2012. But there have been a number of consequences:

  • Companies operating facilities that are tied to crude oil as a feed have seen profits fall (some in the US, but mostly in Europe and Asia)
  • The push to ethane feed has limited co-production of other important basic chemicals, such as propylene and butadiene and prices have increased dramatically, raising prices for a period well above ethylene (something we have not seen in the past)
  • These higher prices have made products produced from propylene and butadiene more expensive relative to ethylene based products and other competitive materials such as natural rubber, and they have felt competitive pressure, limiting demand growth more than could be explained simply by the weaker economy
  • Companies are exploring and investing in alternate technologies to make both propylene and butadiene, which would likely not make sense in a more normal crude/natural gas price environment
  • In effect, normal competitive and market dynamics are finding solutions to the changing environment

But there are changing dynamics on the feedstock side also, that may be underestimated today. As more natural gas is produced in the “wet fields” of Eagleford and Marcellus and as more associated gas comes to the surface in the Bakken oil field, we are seeing increased production of propane as well as ethane. Propane is now in significant surplus in the US and pricing has decoupled from crude oil – the propane/crude ratio is now looking like the ethane crude ratio of 24 months ago – Exhibit 11.

Exhibit 11

Source: IHS and SSR Analysis

 

The chemical industry is reacting to this in a couple of ways – but predictable ways.

  • There is an initiative to increase propane exports to Europe as a feedstock. This makes sense where import infrastructure is in place.
  • There are initiatives to build propane dehydrogenation facilities in the US to turn the propane into propylene. This makes less sense is our view.

While it is not practical to push ethane though an ethylene plant designed for crude oil fractions such as naphtha and gas oil – the cost of refitting the unit would perhaps be greater than building a new facility – you can push propane through relatively easily, without much capital expense. Moreover, “cracking” propane yields very high propylene to ethylene ratios. While the current cash cost of production of ethylene from propane is not as low as the cost from ethane, it is low enough and close enough to possibly offset the alternative capital costs of building a de-hydro plant to make the propylene on purpose. i.e., if you are short of propylene and if you have the flexible capacity you would be better off switching from ethane to propane as a feed, despite the higher cash costs, as the increased cost still provides a better NPV than the cost of building a new de-hydro facility.

One final and somewhat heretical thought on the subject today – but a theme that is ripe for further work.

The chemical industry loves to build stuff, and universally the industry sees the NGL situation in the US as its opportunity. The industry is contemplating spending tens of billions of very risky dollars over the next 5 years to “exploit the opportunity”. But let’s look at this another way and perhaps the right way – the E&P industry in the US has a problem without a market for the NGL’s, it cannot produce the natural gas. This is as much an E&P “problem” as it is a chemical industry “opportunity”. Despite this, the chemical industry has jumped in with both feet and is taking all of the capital risk. At best, the chemical industry has a relatively secure supply of NGLs for a while, but with no price guarantee and more important in our view, no relative price guarantee versus crude oil. The movement in propane pricing over the last few months is illustrative of the fluid nature of pricing dynamics. The chemical industry is taking all the risk here and perhaps some shared risk investments with the E&P industry would make more sense.

Portfolio Performance

For November we have a group with overlaps on the long side and on the short side (Long DD, OLN and ROC and Short CYT, EMN and SHW). Changes in the overlap group from October include OLN replacing HUN on the long side and EMN and CYT replacing RPM and WLK on the short side. The November selections are shown in Exhibit 12. We will publish the end November screen in a short note in early December.

Exhibit 12

Source: Capital IQ and SSR Analysis

We have back tested the methodology from April through September and we show these results and the performance since we created the screens in Exhibit 13. We had generated good results for the overlap group through mid-September, but it has since done poorly. This month’s lackluster performance is primarily the result of SHW, which continued to climb higher on its acquisition news; our short side portfolio results were skewed as a result but any further outperformance will increasingly suggest a valuation peak.

Exhibit 13

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Spending numbers were revised up for August and continued to increase in September – Exhibit 14
  • The longer-term spending trend remains positive – Exhibit 15
  • European spending and sentiment numbers continue to drift lower

Exhibit 14

Source: BEA

Exhibit 15

Source: BEA

Construction

  • After flattening slightly in August, construction spending ticked back up again in September – Exhibits 16 and 17
  • Stocks within the chemical space that are exposed to this sector continue to show some resilience (with DOW and DD the exception), anticipating a return to a positive trend. However, machinery stocks are well off their highs of the year and appear to be discounting more bad news – there is an inconsistency here with some diversified and specialty chemical companies
  • The picture outside the US has not changed materially

Exhibit 16

Source: US Census Bureau

Exhibit 17

Source: US Census Bureau

Agriculture

  • Although well above last year’s levels, wheat, corn and soy pricing has recently come off of its highs, and the downward trend largely continued over the past month. The sub-sector has seen some weakness as a result– Exhibit 18. Soy in particular has fallen off sharply from its September peak while wheat actually posted a small gain since our last report

Exhibit 18

Source: Capital IQ, SSR Analysis

ISM

  • The ISM Purchasing Managers Index was up marginally in October to 51.7, just above the critical 50 level that defines growth and contraction. Exhibit 19 shows the shorter term data that we find concerning and Exhibit 20 shows the longer-term PMI trend
  • The troubling trend of increasing inventories and decreasing production has begun to reverse though we will continue to monitor these indicators in a highly uncertain demand environment
  • We still do not see enough positive news here for us to feel any less concerned about 2012 earnings – we continue to expect negative revisions through the fourth quarter

Exhibit 19

Source: ISM

Exhibit 20

Contraction

Expansion

Source: ISM

Trade

  • Chemical trade volumes spiked back up in September, and clearly remain volatile. Despite an uptick in natural gas pricing in the near-term, the forces here are weaker demand in Europe and Asia offset by much lower production costs in the US – Exhibit 21
  • If the US is going to get real advantage from its lower natural gas prices, we should expect to see this line trend upwards. The September rebound did not prevent earnings disappointments, and generally cautious corporate guidance suggests global demand weakness will be a continuing concern moving forward.
  • The dollar continued to weaken against the Euro since a low in July – Exhibit 22. The third quarter of 2012 saw the dollar stronger against the Euro year on year by around 11.5% – Exhibit 23. This is better than we were predicting at the beginning of the quarter

Exhibit 21

Source: US Census Bureau

Exhibit 22

Source: IMF

Exhibit 23

Source: IMF

Commodity Fundamentals

Supply/Demand

The charts are updated by 1 quarter but the text is unchanged from the Mid-October report as none of the issues have changed – our demand and export concerns were covered in detail in a piece of research published in October.

US Ethylene production has declined slightly from a peak earlier in the year. This peak is well below the production peaks seen in 2007, 2005 and 2000 – Exhibit 24. While the decline in consistent with some of the broader economic news, it is not consistent with the significant cost advantage enjoyed by US producers today. The decline is more pronounced when you look at operating rates, which on a rolling historic basis have dipped below 90% of capacity – Exhibit 25. Again, this makes perfect sense when taken in the context of the broader global economic environment, and the picture for Europe will look much worse.

However, the expected wave of investment in new ethylene and derivative capacity in the US is predicated on the ability to force that product into other markets because of the cost advantage in the US. The cost advantage today is as good as it has been at any time in the past, despite the recent pull back in oil and it is likely better than the assumptions behind any of the capital cases used to justify the new investment. If the US cannot maintain high operating rates in this environment it calls into question whether these expansions make sense.

Exhibit 24

Source: IHS and SSR Analysis

Exhibit 25

Source: IHS and SSR Analysis

Pricing

Energy – Exhibit 26

Both Brent and WTI crude oil prices have declined since the end of October. The underlying commentary is unchanged, and while we have seen some more positive economic signs, they are only incremental and may be a continuation of the noise that we have experienced for the last year or so. Fundamentally the market looks oversupplied, but politically/emotionally the market is skittish as Middle East tensions ebb and flow. There remain articulate arguments about why oil should hit $150/barrel before year-end and equally articulate arguments as to why it should hit $50/barrel in the same time frame. With weaker economic output everywhere and high prices for gasoline and distillate around the world, it is not demand that will drive prices higher in the near-term.

After spiking above $4.00/mm BTU in mid October, natural gas prices came off in the aftermath of Hurricane Sandy, but remain at the highest levels seen in a year.

Exhibit 26

Source: Capital IQ

NGL pricing remains very weak; as with ethylene production lower, demand is weaker in the US. Supply is rising as more and more new wells are drilled in the “wet gas” regions of the West Marcellus and as logistics help increased crude shipment from the Baaken shale play in The Dakotas, Wyoming and Montana. This crude has high levels of associated gas in many locations. Ethane margins remain subdued – and in November have fallen to effective break-even levels (Exhibit 27). While this is very good for ethylene producers in the US, propane is also becoming an attractive alternative, particularly for those companies short of propylene and having to buy propylene at the margin. Increasing supplies of both ethane and propane today, while demand remains subdued suggest that the expected NGL surplus is with us perhaps a little earlier than expected – most had been projecting Q1 2013.

Exhibit 27

Source: IHS and SSR Analysis

Basic Plastics

Lower input costs in October and November have allowed polymer margins to stay relatively flat despite weaker pricing. International pricing remains weak, because demand is weak, but much higher international costs set a floor price that is not too far below US prices – 15-20%. If US prices fell to international levels, which is possible if the demand environment remains weak and production economics remain attractive, US producers would still see very healthy margins – Exhibit 28. See recent research for more commentary of global polyethylene price dynamics.

Exhibit 28

Source: IHS and SSR Analysis

Valuation Charts

The exhibits below show our mid-cycle “normal” valuation framework for the chemical sub sectors and the first exhibit (29) summarizes the results and is a repeat of Exhibit 1.
Exhibit 29

Valuation Charts – Exhibits 30-32

Exhibit 30

Source: Capital IQ and SSR Analysis

Exhibit 31

Source: Capital IQ and SSR Analysis

Exhibit 32

Source: Capital IQ and SSR Analysis

Skepticism Analysis

We have updated the charts and tables from the Skepticism work that we completed in May – see our past research for more detail .

The primary conclusions are:

  • A strong move to the upside in subsector cap leader ECL since our last Chemicals monthly has the Specialty group now joining Ag Chem and Coatings as the groups reflecting valuations that anticipate an increase in return on capital from current levels. The other subgroups all have values that anticipate a fall in returns on capital – Exhibit 33
  • The gross margin trend analysis suggests that this expected decline is probably appropriate for commodity chemicals, but much less so for the diversified group
  • The gross margin analysis calls into question whether the coatings sector should be discounting further improvements in returns on capital as the sector is already over-earning – Exhibit 34

Exhibit 33

Source: Capital IQ and SSR Analysis

Exhibit 34

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

October 9, 2012 – Commodity Chemicals: Building in the US, An Adventure or An Investment

October 9, 2012 – Coatings Expensive? The Sellers Seem to Think So (Blog)

Appendix 1 – Exhibit 1 Analysis

In Exhibit 1 the following apply:

  • Green is good – Red is bad. The more intense the shade of green or red the more interesting or negative the factor looks for the sector.
  • Length of bar – wider signifies more important
  • Arrow direction – “Up” means the situation is becoming more positive from a stock selection perspective. So a green valuation bar with an upward arrow means that the stocks look cheap from a valuation perspective and they are getting cheaper. A red ISM bar with a downward arrow means that the ISM numbers suggest downside and they are getting worse.
  • Arrow size – how significant the move is.

Input Analysis

In the input analysis bar we attempt to show how important the natural gas/oil advantage is for each sector (length of bar); how positive it is (color of bar); and which direction it is moving (direction of arrow).

Demand Analysis

For each of our industry sub-sectors we have taken company by company data and generated an average segment exposure. For some companies this information is provided explicitly and for others we have taken estimates from presentations, annual reports and other sources. The segment break-downs are summarized in the charts below: Exhibits 35 to 39.

Exhibit 35


Source: Company Reports and SSR Analysis

Exhibit 36

Source: Company Reports and SSR Analysis

Exhibit 37

Source: Company Reports and SSR Analysis

Exhibit 38

Source: Company Reports and SSR Analysis

Exhibit 39

Source: Company Reports and SSR Analysis

We have then grouped the categories into buckets for which we can measure growth drivers. Those groupings are summarized in Exhibit 40 below.

The first table summarizes the data in the pie charts above and then shows which market driver we use to model each end market. The second table then breaks each sub sector into these market driver buckets and then adjusts for how much business is in the US and how much is external. We add a factor which we call “trade” which brings into play the US trade balance and the strength/weakness of the dollar.

This analysis then drives the “Demand” section of the schematic in Exhibit 1.

Exhibit 40A

Source: Company Reports and SSR Analysis

  • Note that for the “trade” component, we have arbitrarily assumed that 25% of offshore sales are influenced by the US balance of trade and by exchange rates, while 75% of offshore sales are influenced by the same factors as listed above. It is more than likely that this is a different split for different sub-sectors and this will be a subject for further analysis.
  • Note also that we have done some initial correlation work to look at the impact of the factors below on revenue growth and it does show that sub-sectors with a greater exposure (in our analysis) to the ISM data (for example) have a greater correlation between the ISM numbers and demand growth. This will also be the subject of future research.

Exhibit 40B

Source: Company Reports and SSR Analysis

Valuation Analysis

The valuation analysis draws from our mid-cycle “normal value” work detailed above and our revisions work also detailed above. We have – for the moment assumed that valuation is 60% of the story and revisions is 40% for each sector. We will test this more empirically in the coming months.

Appendix 2

©2012, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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